“This year’s credit market is a far cry from the fragile, illiquid one that was seen in 2018”, BofA’s Barnaby Martin writes, in a note dated Friday.
The paradox of 2018 (and Q4 especially) is that while painful, the cross-asset malaise that found some 90% of global assets underperforming USD “cash” served to underscore central banks’ addiction liability, thereby compelling policymakers to beat a hasty retreat. If it was inevitable that central banks would eventually give normalization a go, to the likely detriment of risk assets, then one might be inclined to retroactively take a glass half-full approach to last year. Something like this: They tried to normalize, it predictably led to a selloff, and now they’ve learned their lesson.”Lower for longer” is “lower forever”. It cannot be otherwise. We needed the 2018 experience to convince policymakers that normalization is a non-starter – to prove to central banks that accommodation must be left in place in perpetuity.
2018 was a stark reminder that, to quote Deutsche Bank’s Aleksandar Kocic, “the only way [for central banks] to avoid facing the underlying dilemma is to never give up power [and] this creates a new status quo – a permanent state of exception.” The rules were effectively re-suspended in 2019 when it became apparent that the full re-emancipation of markets would be accompanied by an unacceptable amount of pain. The U-turn is visualized in the following chart, which shows the difference between the number of central banks that have raised rates and the number that have cut rates on a six-month rolling basis.
For at least a half decade, critics of the post-crisis DM monetary policy regime have trafficked in drug addiction memes in an effort to communicate the extent to which markets were hooked on easy money and abundant liquidity. The addiction metaphor (e.g., “monetary heroin”) long ago passed the overused threshold and has since persisted in the realm of ubiquity. You can still draw the parallel between drug addiction and central bank accommodation (and sometimes there’s no more apt way to communicate the dynamic), but it feels unnecessary.
The main consequence of a return to accommodation and to a state of affairs where policymakers will be especially keen on making use of forward guidance, is a reinvigorated hunt for yield – a return to carry mania. That, of course, is to the benefit of credit, and dodgy credit in particular.
“While trade tensions have taken the wind out of the credit market’s sails over the last fortnight, they have far from derailed the strong bid for bonds”, BofA’s Martin wrote Friday. “In fact, the last two weeks has seen a combined €45bn of high-grade new issuance emerge, in tandem with heavily oversubscribed order books.” Martin is the bank’s European credit strategist, so the analysis is through that lens, but it’s always couched in terms that make his notes amenable to the broader macro narrative.
Martin has, in the past, spent a ton of time talking about how QE creates “zombies.” We’ve been over that and over that. He revisits it this week.
Read more on ‘zombies’
After noting that “the return of hubris across fixed-income markets” is down to central banks being back in the business of protecting risk, Martin rehashes “the dark side of stimulus.” “The risk with such extended periods of monetary largesse is misallocation of capital”, he laments.
It’s a familiar refrain. But the implicit warning is never heeded precisely because accommodation has never been meaningfully rolled back – or at least not for a long enough time period to allow for price discovery to purge misallocated capital and malinvestment.
The “zombie” characterization follows naturally from there. Here’s Martin, recapping:
Rather than financial markets efficiently allocating capital to productive, growth-rich companies, investors’ desire to reach for yield amid a low rate world means inefficient, ex-growth firms are able to secure funding and roll-over debt. The end result is impressively low default rates, but also a clustering of companies across the market where their long-term existence is highly questionable. In other words, easy money creates a lifeline for “zombie” firms to persist.
In his updated zombie tracker, Martin finds that around 6% of European companies are zombies, where that means they’ve had interest cover ratios <1x for four consecutive quarters. That 6% figure sounds low, and it is, but it’s up 50% from Q3 of last year. “Peak zombie” was in the second quarter of 2016. The recent uptick is being driven by tech (see the breakdown in the right pane below).
Again, it’s not the 6% figure itself that’s disconcerting (or even interesting), but rather the trend. “To be clear, this is still a low number relative to the last 10-15yrs, and way down from the recent peak of over 11% [but] the consistent decline in zombie companies witnessed in Europe over the last 3yrs now looks to be going in reverse”, Martin writes, on the way to warning that “given our methodology (4q average), this number is likely to keep rising for the remainder of 2019.”
Martin next expands his analysis to include a new category: “broad zombies”. These are companies with either revenue growth less than EU GDP growth, leverage (net debt/Ebitda) > 4x, YoY EBITDA margin growth negative, and YoY capex growth less than EU business investment growth. To be a “broad zombie”, you have to have exceeded those metrics on a four-quarter rolling basis. The chart below shows the percentage of companies that meet three or more of the total five criteria (i.e., those four metrics plus interest coverage <1x). Here’s the chart on that:
Clearly, the picture is less benign for “broad zombies” than it is for “narrow” ones.
“The number of broad zombies across Europe has been rising for much longer than the narrow zombies [and] in fact, the trough in broad zombies was in Q3 ‘17 at around 10%”, Martin says, noting that “since then, the number of zombies has risen to 12%.”
The implication from the above is that while the ECB managed to “cure” (temporarily) some zombies by creating a voracious hunt for yield and favorable refi conditions, the overall economic picture in Europe has not improved enough to reduce the number of “broad zombies”
“While debt costs were coming down, earnings growth and pricing power metrics were still being heavily impacted for many companies given the disinflationary backdrop in Europe”, Martin explains.
The upshot is that corporate vulnerability in Europe is on the rise again and political uncertainty, as well as ongoing concerns about the outlook for the global economy amid the trade war, could make things worse.
For policymakers, the message is clear.
“Too fast a rush to normalize policy — to relieve the stigma of negative rates for instance — risks pushing these zombie firms into default as interest costs rise”, Martin warns. He also says the same applies to policymakers who might consider normalizing just for the sake of freeing up countercyclical breathing room or, to quote Martin, “likewise for central banks who feel the need to raise rates just to create ‘ammunition’ for the next economic downturn.”
That latter bit speaks to another paradox of the normalization effort: Raising rates and letting the balance sheet runoff in an effort to replenish “ammo” before the cycle turns risks bringing forward the end of the cycle. Put differently, normalizing for the sake of freeing up room to ease when the next recession hits, chances accelerating the timetable on that recession. It’s cruelly ironic, but it was also wholly predictable.
Martin’s advice to central banks: “take it easy”. Because, while zombie apocalypses are fun to watch on TV and in the movies, all the available evidence suggests a real one wouldn’t be very pleasant.